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Tuesday, March 10, 2009

US debt: When 'Judgment Day' comes

March 10, 2009ST-NUS BUSINESS SCHOOL SERIES ON GLOBALISATION

By Sam Ouliaris

HOWEVER you look at it, the debt of the United States federal government is huge. As of March 8 this year, it stood at around US$11 trillion (S$17 trillion) - approximately US$36,000 per US resident). And since 2007, it has been growing faster than nominal gross domestic product (GDP). The result is a slow but steady rise in the debt-to-GDP ratio.

The 'public' - including foreign central banks - currently holds about US$6.5 trillion of the debt, and 45 per cent of this amount (US$3 trillion) is owed to foreigners (mostly the central banks of Japan and China). The remainder of the debt is owned by US federal agencies, such as the Social Security Administration.

These estimates do not include the cost of the 2008 financial crisis, which will add at least US$1.5 trillion to the tally. According to the US Congressional Budget Office, these costs will raise the public debt-to-GDP ratio to 50 per cent by the end of this year.

The long-term outlook for the US federal debt is even worse. Under existing laws, mandatory spending - such as Social Security, Medicare, Medicaid and interest on the debt, none of which can be reduced without an act of Congress - will exceed tax revenue some time between 2030 and 2040. After that, any discretionary spending - for defence, education, et cetera - will have to be funded through borrowing.

A rising national debt is not a problem necessarily if the borrowing enhances the economy's growth potential through targeted investments on infrastructure and human capital. However, to ensure that the debt-to-GDP ratio eventually declines, the return on such investments will need to be greater than the interest paid on the corresponding debt.

Such a favourable outcome is unlikely in the case of the US. This is because the bulk of the government's future borrowing has already been promised to an ageing population, one that is more likely to spend on non-durable goods and services rather than invest in the future.

The government will therefore be forced to finance 'productive' additions to the capital stock - schools, roads and bridges - through additional borrowing. Doing so will almost surely place upward pressure on long-term interest rates, and consequently lower private investment growth and labour productivity. And that in turn will make it even more difficult for the government to reduce the debt-to-GDP ratio through strategic investments.

Worrying about events that might occur 30 years hence might seem rather futile. However, owing to the way financial markets operate, 'Judgment Day' will arrive much earlier than 2040. Given the rising debt-to-GDP ratio, prospective lenders to the US will conclude that the US dollar will need to decline over the long term. That will make them reluctant to accumulate US dollar-denominated government bonds.

It may even encourage them to reduce their existing holdings of US assets. But unwinding their exposure quickly could be self-defeating as a large sell-off will significantly reduce the value of the US dollar and hence the value of their existing holdings.

As the exchange rate declines and the debt grows, nominal interest rates will need to rise to entice investors to buy US dollar-denominated bonds. Moreover, US inflation will be higher because of higher import prices due to the falling exchange rate. The US economy will inevitably be pushed into a lower investment and growth path.

In the worst-case scenario, if the US government found it difficult to finance its operating deficit by issuing bonds, another financial crisis could arise. As the events of 2008-2009 have painfully demonstrated, this will cause adverse spillovers for the global economy.

Since the US dollar is currently the world's reserve currency, one option for tackling the debt would be for the US government to print money. However, without a corresponding increase in global output, printing money would create a vicious circle of higher inflation and higher nominal interest rates. The US will suffer from hyperinflation, an even lower dollar exchange rate and financial default.

Since financial default is not an option, the US government clearly has no choice but to save more, either through lower government spending and/or higher taxation. It follows that the ability of the US to act as the locomotive of global growth will diminish as it turns to the task of reducing its debt.

In the absence of other low saving nations, greater US saving will leave the global economy more vulnerable to large shocks such as the 2008-2009 financial crisis. Imagine how long the current recession would be if the US were unable to increase its expenditure because of a high level of debt.

While it remains unclear which country (or group of countries) will be able to take on the important role of being a spender, a positive development would be for emerging market countries like China to work collectively towards becoming the new engines of global growth in the medium term. This would require a gradual shift from their current export-led growth strategies, which are overly dependent on the health of US economy, to strategies that depend more on their own domestic consumption and investment growth.

In the near term, policies promoting more flexible exchange rates and less public and private saving in emerging markets would help to reduce the global economy's dependence on the US.

The good news is that globalisation, through the normal workings of the free market, is helping to bring about the needed adjustments by increasing the size and wealth of the middle class, especially in emerging markets. This growth brings with it huge potential for consumption that will eventually support growth in the US as it tackles its debt problem. Globalisation should therefore be embraced rather than feared.

The writer is professor of business policy and economics at the National University of Singapore. This is the fourth in the 12-part ST-NUS Business School Series on Globalisation.